––– a weblog focusing on fixed income financial markets, and disconnects within them

Tuesday, November 27, 2012

Not for Profit Sovereign Ratings Become a Reality

Last week, the Bertelsmann Foundation issued ratings and supporting research for five sovereign bond issuers – Brazil, France, Germany, Italy and Japan. The individual country reports, a summary and a description of the rating methodology are available at http://www.bfna.org/.

The publication of these reports marks a substantial milestone. The Foundation has delivered on the ideas outlined in its April 2012 blueprint for an International Non-Profit Credit Rating Agency (INCRA). It has shown that a not-for-profit organization can produce quality sovereign credit research competitive with that offered by incumbent rating agencies. Further, unlike commercial players, this not-for-profit agency consistently implements a transparent rating methodology.

Last week’s reports show that the Bertelsmann Foundation can produce very detailed research. This should not come as a surprise, since the Foundation has experience in producing comprehensive research in support of its Sustainable Governance Indicators and Bertelsmann Transformation Index. Many think tanks and academic research groups produce reports that compare multiple governments and other institutions. The data collection and interpretation processes used by these non-profits are analogous to those required to rate sovereign governments.

The consistency and transparency of the reports is also noteworthy. The Foundation scores each country according to several dozen macroeconomic and forward looking indicators. The score for each indicator is reported, a published algorithm is used to aggregate the scores and the composite score is converted to a letter grade via a standard mapping.

It is not clear whether the Bertelsmann Foundation plans to issue more sovereign rating research. Comments from organizational leaders suggest that this set of reports constitute a pilot and further steps would have to be taken by a new organization – ideally one supported by an endowment to the tune of $400 million. The endowment would enable the rating organization to operate free of the need to generate income and the temptations for bias such a need entails.

My own view is that biases can be addressed through transparency. If others can look under the kimono, assumptions and procedures that introduce bias can be flagged - placing pressure on the rating issuer to correct them. Since $400 million is not likely to be found in the NGO world, there has been some discussion of securing INCRA funding from the G-20. But a group of sovereigns funding a sovereign rating process could be an invitation to bias.

Also open to debate is the choice of indicators Bertelsmann used to derive its sovereign ratings. For example, it is not clear how a country’s environmental policies affect its ability or willingness to pay interest and principal. This is especially true of the regulation of greenhouse gas emissions – which have global rather than country-specific impacts.

A number of indicators address the health of the country’s democracy and the degree to which individual rights and political participation is encouraged. I don’t believe these indicator choices will find theoretical or empirical support. Indeed, Reinhart and Rogoff reported that Communist Romania ensured debt repayments to foreign creditors by depriving the public of heat during the winter. It’s hard to see how this would have happened in a more democratic environment. More generally, to the extent that government expenditures other than debt service enjoy political support, greater democratic participation can be expected to be a negative factor for bondholders. It would be preferable if the opposite were true, but successful investing requires an objective appraisal of the information at hand – rather than a hopeful one.

To gain credibility, new sources of sovereign ratings must tell investors something they find useful. Foremost on the minds of sovereign bond investors are the questions of how likely is a default and when might a default occur. Our Public Sector Credit Framework addresses these questions directly by estimating the risk that a sovereign will reach an unsustainable threshold in each upcoming fiscal year. Because PSCF uses open source software and transparent models it combats bias.

Open source approaches can also lower start-up costs by encouraging community participation in software and methodology development. To maximize the opportunities for community development, we are teaming up with Wikirating.org – a platform that seeks to employ multiple methodologies to crowd source credit ratings. Under our agreement, we continue to operate independently while sharing content. We welcome the Bertelsmann Foundation and all others interested in transparent alternatives to status quo credit ratings to partner with us as well.